Thursday, November 5, 2015

As unnecessary as it may seem, contrarian investment managers need to be even more consultative with their clients than managers more aligned with market sentiment, otherwise clients won't be able to handle the extended periods of relative underperformance a contrarian investor is likely to face from time to time. In the case of GMO, while the long-term performance of many of their strategies is pretty strong (and tend to materially outperform when markets turn), the performance captured by their investor base is typically quite poor.

One example being the GMO Benchmark Free Allocation III, a fund in which the average investor has underperformed the fund by 3-5+% over 3, 5, and 10 years. As a result, despite a 16th percentile Morningstar rank in terms of fund performance over 10 years, investor performance only ranks 74th.

In other words, their investor base historical zigs when they should zag... adding money to the contrarian GMO after markets have tanked (when they should be taking market risk) and piling out of the contrarian GMO after markets perform well (when they should be taking risk off the table). Thus, it was relatively alarming to see that funds flows at GMO have been negative $4.2 billion over the twelve months through 9/30/15, including almost $3 billion of outflows the last two months of the third quarter alone.

How poorly have investors timed GMO? Let's take a look at how well a model doing the exact opposite of GMO flows would have performed going back 20 years.

Rules:

If twelve month flows to GMO funds are positive, allocate the next month to stocks (S&P 500)

If twelve month flows to GMO funds are negative, allocate the next month to bonds (Barclays Agg Bonds)

The result of which is more than 100% of the S&P 500 with almost half the volatility and drawdown.

I have a ton of respect for the way in which GMO manages money (their guts to be massively contrarian if that is their view) and I think their thought leadership is about as good as it gets in the industry. The challenge is GMO knows they are smarter than their clients, leading to a more-or-less 'take it or leave it attitude'.

But what good are strong long-term returns if an investor is unable to capture them?